Residual value of a car refers to a car's estimated dollar value at the end of its lease and/or its useful life. The actual residual value of a particular car always varies. Residual value is essentially an estimate of what that specific car’s wholesale value will be in a set period of time (usually between two and five years).
The wholesale value of a used car is an estimate of how much a car might sell at auction. This estimate arises from a history of similar used vehicles selling under similar circumstances.
Who Determines a Car's Residual Value?
As of 2018, auto lending companies determine the residual value of a given car; the dealer does not determine this value. The lending company calculates, or obtains, the residual value of a car by:
- Consulting a leasing guide
- Calculating a percentage of the Manufacturer's Suggested Retail Price (MSRP)
Automotive Lease Guide (ALG) is the industry benchmark when it comes to a car's residual value. ALG publishes an annual Residual Percentage Guide for reference. Residual values in the Residual Percentage Guide are an authoritative prediction that most of the auto industry follows. ALG residual values are not etched in stone, and lenders take the liberty to establish unique residual values even for the same vehicle in the same condition.
Similarly, calculating a percentage of MSRP leads to residual values that differ between lenders. One lender calculates the residual value at 30 percent of MSRP. Another lender calculates the residual value at 40 percent. Both residual values may apply to the same vehicle at the end of a 36-month lease and these values are not negotiable. This is why it's advisable to shop around for multiple lenders. It's possible to come across a range of residual values for any vehicle you're thinking about leasing.
How do You Determine a Car's Residual Value On Your Own?
Consult lease guides like ALG, which are available via annual subscription. There are free alternatives online, such as Kelley Blue Book. Some online tools give you a prediction of your car's residual value, whereas other tools allow you to input information and parameters beforehand. The tool then calculates your car's residual value based on your input and established parameters/refinements.
Online person-to-person car sales websites are another idea. These websites often offer some tool that calculates residual car values, trade-in value or trade-in range so that you can post your for-sale vehicle at the most competitive price. On the surface, residual value and trade-in-value seem different. However, trade-in value is an estimate of what a used car might fetch at auction, which is one of the metrics used to determine residual value.
How Does ALG Establish Baseline Industry Standards?
ALG tracks how vehicles depreciate over time. Based on extensive experience with vehicle depreciation, ALG produces residual value forecasts. The residual value, or expected wholesale value, is the price that your used car might fetch at auction. This forecast calculation includes the price history of similar vehicles sold at auction.
The lender (or bank) uses the ALG residual value forecasts, its own set of past models and its own predictions to establish a unique residual value for a given car. This value (which includes depreciation), along with interest and tax, impacts the amount of your car's monthly lease payments. As a result, the lease offer from the lender is the one that he or she thinks is the most competitive, profitable and compatible with the lender's most comfortable level of risk.
Some manufacturers subsidize leases. The contracts for these leases often quote slightly higher residual car values than those from ALG. These higher values let manufacturers lower the lease payments, which some consumers may find more feasible.
What is Residual Value in Relation to MSRP?
MSRP only applies to new, unused cars. The moment you buy a car or drive it out of the lot, its value diminishes. This is why residual value represents a percentage of MSRP. MSRP is a manufacturer's calculation of retail pricing. The price is suggested. MSRP does not reflect what a car actually sells for or even what it actually costs.
Manufacturers use a variety of formulas and methods to determine MSRP. The basic formula is: Cost of product + markup = MSRP.
The Importance of Knowing Residual Car Value
After you drive a new car off the lot, the value continues to depreciate the more you use it. The largest portion of your monthly lease payment covers the cost of depreciation. Does it follow that a car with a high MSRP automatically has a higher value depreciation? On the contrary.
Sometimes it makes more sense to lease a luxury vehicle that happens to have a higher MSRP. A well-made luxury vehicle depreciates less over time, meaning your monthly lease payment may end up being lower than a monthly lease payment for a cheaper car whose value rapidly depreciates over time. Since the luxury car depreciates at a lower rate than the economy car, it retains more residual value/resale value.
High residual car value is so prized, the industry grants annual awards to manufacturers whose vehicles depreciate the least over a three- to five-year period. Pay attention to manufacturers who are awarded ‘Highest resale/residual value’ awards from independent third-party outlets as this is a key indicator of which brands and models hold their value the most.
Knowing residual car values helps you make more sound decisions about what's worth leasing. Whether your future car is luxury, sporty or economical, your car's ability to retain value automatically means lower monthly lease payments. It also means you derive greater actual, perceived and overall value form your car for years and years to come.